EMBA 807

Corporate Finance

Dr. Rodney Boehme

CHAPTER 5: HOW TO VALUE BONDS AND STOCKS
(Assigned problems are 1, 4, 5, 7, 8, 9, 13, 16, 17, 18, 21, 22, 23, 25, 26, 29, 31, and 33. Omit the Appendix to this chapter). This notes package contains two Addendums.

I. BOND VALUATION
Bonds are “Fixed Income” securities, since the cash flows that the bondholder will receive have been fixed or prespecified in the bond contract. The current fundamental or intrinsic value of a bond (or any other financial asset) is equal to the Present Value or PV0 of all future expected cash flows.1 An investor’s actual return on a bond, for any holding period, comes in two forms: (1) the coupon yield (from the payment of coupon interest) (2) the capital gain (bond’s change in price)

Zero Coupon Bonds: a zero coupon bond will pay its stated face or par value
at maturity. It pays no other future cash flows during its life. Zeroes are also known as pure discount bonds. The return here comes entirely as a capital gain. Example: A zero coupon bond will mature exactly 2 years from today. It was sold or issued by the U.S. Treasury and therefore is free of default risk. The par or face value is $100. This bond currently sells for $84.17 in the market. What annual rate of return does the market expect on this bond? From Chapter 4, we know: PV0 = FVn/[1 + r]n. Here, PV0=$84.17, FV2=$100, and n=2 years. We need to solve for r. A time line of this bond is shown below:
t=0 PV0 = 84.17 t=1 t=2 FV2 = 100

PV0 = FVn/[1 + r]n → r = [FVn/PV0]1/n – 1 = [100/84.17]0.5 – 1 = 0.09 or 9.0% Actually, anytime we calculate the annual yield r by using the current bond price and future payments, the r is referred to as the Yield-to-Maturity or YTM. What will happen to this bond’s price tomorrow if the current market rate of interest or YTM on this and similar two-year bonds falls from 9.0% to 8.8%?
Intrinsic value refers to a private estimate of value – a private estimate of Present Value. This is not the same concept as market value, which refers to the current price at which a bond or stock is trading for.
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it has 10 years remaining until maturity. 1  1 PAR PV0 = C  + n  r r (1 + r )  (1 + r )n    1  1 1000 PV0 = 90   + 10  0.085)  (1 + 0.52 + 442.085(1 + 0. Most coupon interest payments are paid every six months or semiannually. As yields fall. The face or par value of the bond is $1000. market conditions are such that investors expect to earn a YTM of 8. Coupon Bonds: most bonds pay coupon interest over their lives. Then there is one lump sum of $1000 at maturity. The bond will pay an annual coupon interest payment equal to 9% of the par value. t=0 t=1 $90 t=9 $90 t=10 YTM = 8. However we will cover annual coupon paying bonds first.088]2 = $84. Example: A bond was issued 10 years ago as a 20-year bond. bond prices rise. Note: the coupon rate of 9% only determines the amount of the annual coupon payment. the bond is now priced to yield the new lower market rate of interest of 8.085)10 PV0 = 590.8% per year. regardless of what happens to the YTM. This bond will pay the $90 coupons.085)10   PV0 = (90)(6. Over its remaining 10-year life.09)(1000) = $90 as a coupon interest payment. After all. A time line of the bond is shown. At this time. the bond will thus pay ten $90 coupons and one amount of the $1000 par at maturity.48. We calculate the Present Value or PV0 of all these payments (the annuity and lump sum). The coupon rate is completely independent of the actual YTM or current market rate of return on this bond. Today.5% $90 + $1000 par The ten $90 coupons represent an ordinary annuity (as covered in Chapter 4) of ten $90 cash flows. Rodney Boehme PV0 = FVn/[1 + r]n = 100/[1+0.561348) + 1000/(1+0.EMBA 807 Corporate Finance Dr.5% on this and similar bonds.81 Page 2 . Each year this bond will pay (0. Here. this is a fixed income security. Bond yields (interest rates) and prices are always inversely related.085 0.29 = $1032. We begin with an example.

respectively.5%. When interest rates or yields fall (rise). bond prices rise (fall).10.81 today if the market requires a YTM=8. an amount that is equal to the YTM. these are the steps: FV = $1000 (the par value) I = 8.60.21.5%. In the last example. we say that the bond is selling at a premium (to par value). and (3) rises to 9.085 or 8. then the price next year will be $1030.81 = 0.5%. The price rises as the market YTM falls.0% 2 Note that in exactly one year. Rodney Boehme The coupon and par payments are worth $590.81+90]/1032. assume that the current market 8.10. Market rates of interest change continuously as economic conditions change.5% to 8.81. An investor’s holding period return for the year is thus [1030. the bond pays $90 in coupons and also falls in price by $2.2 Bond Prices and Interest Rate Changes: The previous bond is worth $1032. (1) YTM falls from 8. the bond has nine remaining years.81. In all cases.79/1032. and thus the price is $1032. Thus investors are willing to pay $1032.0% (the new YTM) N = 10 PMT = $90 P/Y = 1 The answer is PV –$1067.29 today (t=0). Thus during course of one year.5% to 9.EMBA 807 Corporate Finance Dr. Page 3 .5%.81 for this bond investment today and expect to receive a series of eleven future payments. (2) YTM rises from 8. ten annual coupon payments of $90 each and one $1000 amount ten years from today.60-1032.52 and $442. If the market YTM is still 8. bond yields and prices are inversely related.0% FV = $1000 I = 8. The only way to obtain a lower (higher) yield or return on any fixed income investment is to pay more (less) for it. (2) rises to 9%.5% (the current YTM) N = 10 (number of coupons and number of periods until the par is received) PMT = $90 (the amount of the annual coupon) P/Y = 1 (since periods and payments are made annually in this case) The answer is PV –$1032.5% YTM: (1) falls to 8%. When the market price is greater than the par value. To work this problem on a financial calculator.81 = 87. and thus the new price is $1067.

EMBA 807 Corporate Finance Dr. Note: here.5% FV = $1000 I = 9. This bond was likely first issued as a 30 year bond 18. t=0 t=0.5 years ago. the Wall Street Journal and other financial sources will quote the YTM. However. The par value is $1000. When the market price is less than the par value. to be paid semiannually. The actual effective interest rate here is something greater than the YTM of 8%. Today.5 year $70 t=1 year $70 t=11 years $70 t=11. means 8% annual nominal.0% (the new YTM) N = 10 PMT = $90 P/Y = 1 The answer is PV –$1000. and thus the new price is $1000. coupon rates are always stated on an annual basis. This bond pays (14%/2)(1000) = $70 every six months as a coupon payment The remaining number of periods in this bond’s life is (11. government treasury bond will mature exactly 11. investors expect this and similar bonds to yield a YTM of 8% per year.5% to 9. The annual coupon rate is 14% and is paid out semiannually.61. However. Rodney Boehme FV = $1000 I = 9.5% (the new YTM) N = 10 PMT = $90 P/Y = 1 The answer is PV –$968. Semiannual Coupon Bonds: most bonds pay coupon interest every six months. and thus the new price is $968. compounded semiannually. the bond price is equal to the par or face value. If a $1000 par bond states a 10% annual coupon rate. (3) YTM rises from 8. the YTM=8%.5)(2) = 23 semiannual periods. that means that 10%/2 = 5% of the par value or $50 is paid every six months as a coupon payment.5 years YTM=8% per year $70 + $1000 par Page 4 . The price falls as the market YTM rises. When the YTM and coupon rate become equal.S. Example: A U.61. This bond’s time line is shown below. we say that the bond is selling at a discount (to par value).5 years from today.

856842) + 1000/(1+0.04 0.71 Calculator method (one of two ways)3: FV = $1000 (the par value) I = 8% (the annual YTM) N = 23 (number of 6-month or semiannual coupon periods until the par is received and the number of actual $70 coupons) PMT = $70 (the amount of the semiannual coupon) P/Y = 2 (since periods and payments are semiannual in this case. and thus the price is $1445. Page 5 . the calculator divides the YTM by m=2 and uses 4% as the effective 6month rate to work this problem) The answer is PV = –$1445.5 years and m=2):   1 PAR  1 + PV0 = C n⋅m  n ⋅m YTM   1 + YTM m m YTM m 1 + YTM m   ( ) ( )  1  1 1000 PV0 = 70  + 0.98 + 405.04 )23    PV0 = (70)(14.04(1 + 0.04)23 PV0 = 1039.71.EMBA 807 Corporate Finance Dr.04 )23  (1 + 0. Everything else stays the same. Rodney Boehme This bond’s current value is found as follows (n=11.73 = $1445.71 Note: working this problem as having annual coupons of $140 each will always produce the wrong answer! 3 The alternate calculator method is to let P/Y=1 and I=4%.

Everything associated with the firm is also expected to grow at the same rate g.EMBA 807 Corporate Finance Dr. The fundamental or intrinsic value of a stock is defined as the Present Value of all future expected FCFE (again. Observe the following time line of expected dividends.. The fundamental stock price P0 can be modeled as follows4: P0 = ∑ (1 + tr )t t =1 ∞ D . Mature or Constant Growth Stocks: This concept was first introduced in Chapter 4. as well as its expected risk. projects having a positive NPV. including earnings. An analyst must forecast the firm’s ability to pay out cash to stockholders in the future. We will assume that the firm accepts all new projects that increase the value of the firm.. Dividends D1 and D2 paid exactly one and two years from today are expected to be the following: 4 A better term would be V0 for value. we will assume that the FCFE is all paid out as a cash dividend. The term r represents the market’s required rate of return on the stock. assume it is paid as dividends) that will be paid out. i. + (1 + r )t Dt + . . STOCK VALUATION Current stock prices reflect today’s expectations of the future cash flow performance of a corporation. rather than P0 which is interpreted as price. In Chapter 10. Rodney Boehme II.. The excess cash that remains that can be paid out to the shareholders is referred to as Free Cash Flow to Equity or FCFE..e. In reality.. Page 6 . t=0 D0 t=1 D1 t=2 D2 t=3 D3 t=4 D4 We usually assume that the D0 (if it exists) has just been paid out and is no longer part of the firm. This dividend stream is expected to grow at g=5% per year. cash flows. Assume that a mature firm has just paid out dividend D0=$5 per share to its common stock. today firms pay out the FCFE by (1) dividends and (2) stock repurchases. With regard to the common stock of a mature firm. and the stock price... sales. we will learn how the r is determined. the dividend stream is expected to grow at a constant rate g as time passes. Here. Expectations concerning the future can never be proven in the present. which is also expressed as P0 = (1 + r ) D1 1 + (1 + r ) D2 2 + (1 + r ) D3 3 + ...

00. Also. P0 = D1/(r-g) = 5.25. just after the D0 has been paid is estimated to be: P0 = D1/(r-g). P0=$58.12-0.5125 The constant growth model is: Pt = Dt+1/(r-g). Extensions of the constant growth model: Here.33.05) = $5. Thus the stock price should increase from $58.25/0. Does this mean that the stock actually sells for $58.33 Thus the Present Value of all expected future cash flows is estimated to be worth $58.33 in the market today? If the analyst is correct about the fundamental value being $58.33 to $75. Rodney Boehme D1 = D0(1+g) = 5(1+0. D1=$5. just after the D1=$5.25/(0. according to this model. P0 = D1/(r-g) → rearrange to obtain → r = D1/P0 + g Using data from the prior example.25 D2 = D0(1+g)2 = 5(1+0.25 is paid out should be: P1 = D2/(r-g) = 5. and r=14%. The stock’s value today. Page 7 .25 Changing the r or g in the constant growth model: What happens to the current value P0 above if the required rate of return decreases to r=12%? P0 = D1/(r-g) = 5.05) = $61.09 = $58.EMBA 807 Corporate Finance Dr.05) = $75.33(1+0.5125/(0.05) = $61. the stock price increases (decreases). the stock price decreases (increases). If the cash flow growth rate g increases (decreases). However.05) = 5. we rearrange the model to explore other aspects. The required annual rate of return on this stock is r=14%.25/(0. note that the following approach also works: P1 = P0(1+g) = 58. If the required return r increases (decreases).00.05)2 = $5.14-0. the stock’s value next year. g=5%. The constant growth model introduced in Chapter 4 can be used to estimate the value of this stock.33.25. then if the stock currently sells for $50 it is undervalued in the market.14-0.33 today.

is not expected to grow at a constant rate? This same analogy can certainly be extended to firms that currently pay no dividends at all. for the next 5 to 15 years. we will assume maturity and constant growth. Also. D6=$0.. P0=D1/(r-g). A model such as the following is used. but these dividends are not expected to grow at constant rates during the near future.00. The expected or forecasted dividends are D0=D1=D2=D3=0.05 = 0. If the firm pays no dividends today (any cash flow is going toward reinvestment in the firm). applies where the cash flows following D1 at t=1 are expected to grow at a constant annual rate g. D4=$0.80..00 t=9 D9=1. D5=$0. What about a firm that. we still must assume that the firm does mature at some future point. The time line is shown below: t=0 D0=0 t=1 D1=0 t=2 D2=0 t=3 D3=0 t=4 D4=0. then we must assume the firm will begin paying dividends at some time in the future and eventually mature. and thus grow at roughly the same rate as the overall economy.25. an increase in share price of g=5% from P0=$58.80 t=7 D7=0.90. Stocks with multiple or nonconstant growth stages: The constant growth model.14 or 14.25/58..0% This analysis tells us that the r=14% required rate of return on the stock comes as: (1) a 9% dividend yield (2) a 5% capital gains yield. and D8=$1.50. but it reinvests all of its earnings into new growth projects.06 Page 8 . Here. The required rate of return on the stock is r=10% per year.33 to P1=$61. Cirrus Corp. where at some time in the future.09 + 0. It has earnings today. if the firm currently pays dividends.g   (1 + r )    Example: Today. D7=$0. like most firms. P0 = (1 + r )1 (1 + r )2 (1 + r )3 D1 + D2 + D3 + . + (1 + r )t Dt D  1  +  t +1   t  r . You expect that Cirrus will pay dividends in the future. all dividends following the dividend at time t+1 grow at the annual rate g.65.90 t=8 D8=1. Rodney Boehme r = D1/P0 + g = (5.g.65 t=6 D6=0. beginning with year 4 (t=4). All dividends after year t=8 are expected to grow at a constant annual rate of g=6%..05 = 0.50 t=5 D5=0. is a growing firm that pays no dividends.33) + 0. . e.EMBA 807 Corporate Finance Dr.

5132] = $14.90 has been paid out.3415 + 0. r=14%.06   (1 + 0.5 The Cirrus stock price at t=7 years is expected to be P7 = D8/(r-g) = $25.4516 + 0. An analyst has estimated the following: D18=$6. and buy low. In going long on a stock (having purchased a stock) you hope to buy low and sell high.10 )7  0.10 .00   +    (1 + 0. Essentially. Note that the term.80 + (1 + 0. The P7 = $25 is deemed the terminal price (value when g becomes constant).24 Short selling is selling a stock that you do not own.00. XYZ is forecasted to pay out nothing before that time.65 + D4 + D5 + D6 +  D  1  +  8   (1 + r )7  r . it is not needed.50 + 0. Calculate today’s estimated intrinsic value..10 )4 (1 + 0.10)5 (1 + 0. is expected to pay its first dividend exactly 18 years from today.0.00. D8/(r-g).49 per share. t=0 t=1 year $0 t=2 years $0 t=17 years $0 t=18 years $6. While D9 is shown on the time line.14-0. just after the dividend of D7=$0. In going short. is very critical. Rodney Boehme We next estimate today’s intrinsic value of this stock. P0 = P17/(1+r)17 = 85. Discount the P17 price back to today to calculate P0.7143 Step 2: Find today’s (t=0) intrinsic value. If the actual market price P0 is below or above $14. hoping that it will fall in price.4618 + [25][0.10)7   0. P0 = P0 = (1 + r )4 (1 + r )5 (1 + r )6 0. and g=7%.10)6  1  1.g   (1 + r )7    D7 0.49 This private estimate of the intrinsic value of Cirrus stock is P0 = $14.07) = $85.4036 + 0. these shares are borrowed and identical shares must later be bought and returned to the owner. P17 = D18/(r-g) = 6/(0. This is the estimated stock price exactly 7 years from now. The goal is to buy back the shares at lower price than they were sold.EMBA 807 Corporate Finance Dr. you hope to sell high.90 P0 = 0.00 Step 1: find the estimated stock price exactly 17 years from today. respectively.14)17 = $9.7143/(1+0. a growth firm.49 then you may want to buy or short the stock. Example: XYZ Corp. The valuation model can be set up as shown below. This is opposite the position of being long or owning the stock. 5 Page 9 .

b)E1 r . then the investment has an annual ROE = 16/100 = 16%.(0. or total capital expenditures minus depreciation). let expected inflation and GDP growth be 3% and 2..16)(0.4)(2. has r=10%. The growth rate is then expected to be g = 3% + 2.0.(ROE)(b) Example: Cash Cow Inc. 2.16)(0.10 .EMBA 807 Corporate Finance Dr. • If ROE = 16% and b = 0.4.0. g = expected annual inflation + expected annual real growth in GDP For example.5%.4) = 0. you can replace “g” with (ROE)(b) and D1 with (1-b)(E1) to obtain the following variant of the constant growth model: P0 = (1 .4% per year. Rodney Boehme Estimating the permanent or long-run growth rate “g”: We now discuss two common methods of estimating the permanent annual growth rate g. then g = (0.10 .064 Corporation Value and Growth Opportunities: Any firm’s current value can be decomposed into two portions: Total firm value = PV of CFs from current operations + PV of future NPV growth activities The first item above is often called the value of assets in place.00) 1. Short run growth rate estimates may certainly exceed the GDP growth rate. it is unrealistic to assume that any firm can sustain a growth rate that exceeds the Gross Domestic Product growth of the economy. a mature firm.33 0. In the long run. retention ratio b=0.40. Page 10 . If a $100 real investment generates $16 per year forever for shareholders. What is the intrinsic value of Cash Cow today? P0 = (1 . g = [ROE x b] ROE is defined as the average future expected annual Return on Equity on the firm’s capital expenditures.5% = 5.20 = = $33. • Using the constant growth model. The firm thus has a payout ratio of (1-b) to the stockholders. next years earnings are expected to be E1=$2 per share.4) 0.5%. respectively. The firm’s retention or plowback ratio b is defined as the proportion of economic earnings “E” that the firm retains and reinvests (invest here means net capital expenditures.064 or 6. and expected ROE=16% on its corporate investments. 1.

The number of existing shares is 20 million.9166 = $34.10-g) → 0.06) = 15.b)E1 r . the earnings equal the dividends paid and will be $100 million per year forever (a perpetuity).3333M/20M = $0. then what is the market’s consensus estimate of g? P0/E1 = (1-b)/(r-g) → 70 = (1-0. Page 11 . as total investment then equals the depreciation). First.14% This growth estimate is certainly unrealistic for a large firm.15 = -15 + 33. so g=0%. If the P/E is 70.15 = $33. Project’s impact on existing stock price value: 18. The firm invests just enough to keep the current assets in production (no net investment occurs. What about a very large mature firm that sells for a P/E of 60 to 80. It costs $15 million today and generates cash flows of $5 million per year forever. It is rearranged to solve for the P/E ratio.3333 million. Rodney Boehme Example: An existing firm has no growth opportunities.3333 = $18.3333 per share Now a new project unexpectedly comes along.6/70 → g = 9.10 – g = 0. Let b=0.4)/(0. estimate the value of the existing shares of stock: P0 = D1/(r-g) = (100M/20M)/(0.EMBA 807 Corporate Finance Dr.3333 + 0.4)/(0.(ROE)(b) Note: P0/E1 = (1-b)/(r-g).9166 per share New stock price: P0 = 33. especially if the nominal GDP growth of the economy is 5 to 6% per year. In this case.4 and r=10%. which is close to the historical P/E average for mature stocks and the overall stock market (such as the S&P 500 index). P0 = (1 . beginning at t=1.25 per share Price To Earnings or P/E Ratios: We revisit the constant growth model.10 – 0.(ROE)(b) → P0 (1 .b) = E1 r . What if the market begins to price the stock using a more realistic growth estimate of g=6%? P0/E1 = (1-b)/(r-g) → P0/E1 = (1 – 0. Required rate of return on the stock is r=15% per year. NPVproject = -15 + 5/0.15-0) = 5/0.

Rodney Boehme ADDENDUM 1 TO CHAPTER 5 This section presents a more integrated treatment of Corporate Finance and stock valuation. Defined here as g = (ROE)(b). ROE = 15%. We further simplify this example by assuming that there is no investment in Net Working Capital (short term assets as shown in Chapter 7) 6 If total capital expenditures are equal to depreciation. and Amortization. The market’s required rate of annual return on the common stock.6 b is also known as the retention ratio. and 10. and thus we allow the interest expense in this example is zero. Also. Capital Expenditures (the new positive NPV investments) Interest expense Corporate income tax rate Depreciation (never a cash flow. the excess cash flow that can be paid out to the stockholders.7 We want to estimate the fundamental or intrinsic value of this firm. basically revenue minus operating costs. b = 40%. EBITDA Earnings before Interest. Depreciation. DEP = $5000. and EBITDA = $9167. Page 12 . Let CE = $6000.000 shares of common stock exist. The current figures apply for the fiscal year that has just ended. Taxes. Net capital expenditures are equal to total capital expenditures minus depreciation. we must define the following items: ROE r b g CE INT T DEP FCFE The firm’s expected average Return On Equity on its future real investments or capital expenditures. First. Proportion of earnings (net income) that is reinvested into the firm as Net Capital Expenditures. T = 40%. based upon its level of risk. then there are no net capital expenditures. let r = 10%. it is a non-cash expense) Free Cash Flow to Equity. Assume that we have a mature firm that is 100% financed by equity or common stock. 7 The r = 10% represents the firm’s cost of equity capital. to be formally illustrated in Chapter 10. Permanent growth rate of a mature firm.EMBA 807 Corporate Finance Dr. We will just assume that the current FCFE0 has just been paid out as a share repurchase and/or cash dividend.

Be aware that this is only a forecast or estimate of the current value.06) = $1590 Now estimate the current (t=0) value of this firm’s equity: Value = P0 = FCFE1/(r – g) = 1590/(0. This firm is expected to trade at a price that is 15 times next year’s earnings or Net Income.975 per share If the current market price were actually less than (greater than) $3.06)] = 15 for the leading P/E ratio.EMBA 807 Corporate Finance Dr.15)(0.06) = $39. In fact.975. this scenario is not likely. all of the above figures used in the calculation of FCFE0 are forecasted to grow by g = 6% per year. while r = 10%. Next year’s (t = 1) forecasted FCFE1.40 or 40%.40] + 5000 – 6000 FCFE0 = 2500 + 5000 – 6000 = $1500 (the $2500 amount is the Net Income) Net Capital Expenditures ≡ Total CE – DEP = 6000 – 5000 = $1000 Retention ratio = b = [Net CE/Net Income] = 1000/2500 = 0. This is technically accurate if the firm pays out all of its FCFE as a dividend. note that b was already given but this is where it originates. then we would believe that this stock is undervalued (overvalued). Calculate this mature firm’s permanent or long-run annual growth rate g: g = (ROE)(b) = (0. RWJ textbook: the text gives P0 = D1/(r – g). meaning that the capital expenditures are expected to generate a higher return than the cost of capital.06 or 6% per year. defined here as P/E = P0/NI1: P0/E1 = 39.000 shares] = $3. Calculate the P/E ratio.10 – 0.750/10.4) = 0.750/[(2500)(1. We don’t know any of these numbers or parameters in the above models with certainty. Page 13 . Note that new Capital Expenditures are expected to earn an average return of 15% per year. Rodney Boehme FCFE0 ≡ [EBITDA – DEP – INT][1 – T] + DEP – CE FCFE0 = [9167 – 5000 – 0][1 – 0. based on what we assume today: FCFE1 = FCFE0(1 + g) = 1500(1 + 0. however.750 Fundamental value is thus [$39.

000 The previous value of the firm. Now we can compare the growth versus no growth values of this firm. here meaning that ROE > r.750 Note that if r = ROE. Rodney Boehme Growth versus No Growth: Assume that the firm has no growth opportunities. FCFE0 ≡ [EBITDA – DEP – INT][1 – T] + DEP – CE FCFE = [9167 – 5000 – 0][1 – 0.EMBA 807 Corporate Finance Dr. Conversely.750.40] + 5000 – 5000 = $2500 for every year Value as no growth = FCFE/(r – g) = 2500/(0..e. CE = DEP. In this scenario. was $39. then new investments will destroy value! Also note one very important item from these Chapter 5 notes: equity valuation takes into consideration all of today’s expectations of future performance. assuming 6% annual growth. Any firm’s value consists of the following: Total Value = PV(no growth) + PV(future NPV growth opportunities) 39. there are no Net Capital Expenditures and also g = 0 and b = 0. Page 14 . Growth opportunities only add value if they have a positive NPV. for each year as the firm invests just enough to offset the depreciation. then future investments have zero NPV and will add no value over the no growth value.000 + NPVGO Thus the NPVGO = $14. i. if ROE < r.10 – 0) = $25.750 = 25.

EMBA 807 Corporate Finance Dr. or what the firm’s current or existing mix of both debt and equity financing currently cost the firm.. while the FCF model is used to value the entire corporation (the sum of debt and equity). which is somewhat different from the FCFE model covered in Addendum 1. V0 = (1 + wacc) FCF1 1 + (1 + wacc) FCF2 2 + (1 + wacc) FCF3 3 + . FCFi = [EBIT][1 – tax rate] + Depreciation – Capital Expenditures – ∆Net Working Capital – Principal Repayments + New Debt Issues The most common practice is to estimate ten individual annual FCFs and then assume maturity or constant annual growth following year 10 at the rate g. 8 WACC represents a weighted average cost of capital for the firm.. At this point in the course. + (1 + wacc) FCF10 10   FCF11   1 +  10   wacc . as the FCF method values the entire firm. there are some disadvantages with covering the Free Cash Flow or FCF model. . we will cover this concept in detail. both stock and debt owners. The FCF can be expressed by the equation shown below — it is important to compare this FCF tool below to the Capital Budgeting cash flow analysis that we will cover in Chapter 7. although there are many similarities. Page 15 .. after the firm has met its obligations and investment needs.8 Free Cash Flow (FCF) is roughly defined the cash that the firm can pay out to its investors. Rodney Boehme ADDENDUM 2 TO CHAPTER 5 Corporate valuation using Free Cash Flows (FCFs): The most commonly used valuation tool by financial analysts the Free Cash Flow (FCF) valuation model. The FCFE model is used to value only the firm’s equity. while Capital Budgeting methods in Chapter 7 value a single project. Once the entire corporate value is estimated. then the debt value is subtracted out. the discount rate or cost of capital that must be used is the weighted average cost of capital or WACC — which is not fully covered until Chapter 12. In Chapter 12. Thus the FCF valuation model most commonly used appears below. First. V0 is the total intrinsic value (enterprise value or equity plus debt) of the firm. Subtract the current debt value from V0 to obtain the estimated equity value.g   (1 + wacc)    The constant growth model as used above obtains V10=FCF11/(wacc-g). and then what remains is thus the estimate of the equity value.

20 0. The WACC of this firm is 10% per year.4627 + [31.0237 million.65 0.50. Rodney Boehme For firms that need infusions of cash for the next few years.10) (1 + 0.80 + + + + + 2 3 4 5 (1 + 0. FCF5=$0. You expect that Trillium will eventually pay positive FCFs in the future. however.0237 million This private estimate of the intrinsic value of Trillium is V0 = $14.80.10) (1 + 0. All FCFs after year t=10 are expected to grow at a constant annual rate of g=6%.80. FCF7=$0. the firm’s equity is thus estimated to have an intrinsic value of $14..50 . . the FCF model allows you to use negative FCFs.0237 million.20. FCF4=$0.10) (1 + 0.10 1.65. after reinvesting all of its earnings into new growth projects.06   (1 + 0.7273 – 0.0.10) (1 + 0. FCF3=-$0. Trillium Corp.24 per share.10) (1 + 0.4618 + 0.50.000 shares of common stock. and FCF10=$1.10)   V0 = – 0. FCF6=$0. beginning with year 4 (t=4). Since this firm has $2 million of debt outstanding (at current market value).00 1.0.4132 – 0.80][0. Page 16 .10.20 1  1.. it must still borrow additional cash to meet its investment needs.00. + (1 + wacc)10 FCF10   FCF11   1 +  10   wacc .0237 – $2 = $12. FCF11/(r-g). Note that the terminal value term..20.EMBA 807 Corporate Finance Dr. is a growing firm that pays no FCF. Example: Today. It has earnings today.10) (1 + 0.272   + + + +  7 8 9 10 10  (1 + 0.3855] = $14.0. If there are 100.4665 + 0.4036 + 0.10) (1 + 0.4665 + 0.10 . V0 = (1 + wacc)1 (1 + wacc)2 (1 + wacc)3 FCF1 + FCF2 + FCF3 + . FCF2=-$0. The valuation model can be set up as shown below.4516 + 0.90 1. as this is the estimated firm value exactly 10 years from now. FCF8=$1. The firm has $2 million of debt outstanding (at current market value).3415 + 0. The expected or forecasted FCFs (all given in millions of US$) are FCF1=-$0.80 .10)6  0. before the FCFs (hopefully) eventually become positive. is very critical.g   (1 + wacc)    V0 = + .50 0. We next estimate today’s intrinsic value of this firm.90.0.1503 + 0.10) (1 + 0. then the stock is estimated to be worth $120. FCF9=$1.10)  0.

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